I have a beginner’s grasp of what a “short fund” is: it’s a fund which is designed to behave in a manner opposite of what the market is doing. When the DJIA is up, shares of a short fund are cheap, and when the DJIA is down, shares in the fund go up. I get this much, although I don’t get how it does this.
If one has a portfolio full of bullish stocks, is it wise to also purchase something like a short fund so that you’re covered either way? Or are short funds a very risky sucker’s bet?
The concept of short-selling is basically that you borrow shares from some third party, and sell them at the current price (say $10 per share for 10 shares).
Then, you’re counting on the price to drop at some time in the future (say $7 per share), so you then buy the same 10 shares back at $7 a share, and give them back to the party you borrowed them from.
At the end of the process, whoever loaned them to you has their 10 shares back, and you have $30 that you made from the difference between what you sold the stock for and what you bought it back for.
I’d guess that a short fund would be a portfolio of securities that are expected to fall in value, so that they’ll short them. I’d imagine the devil would be in the details of how you’d valuate the fund’s shares.
It depends.
Shorts can be used to hedge investments, but you still need to have a plan, and you’ll still take some risk. There’s no way to make a magic portfolio that will never lose money; all you can do is protect yourself from specific risks.
Let’s take the naive hedge as an example to show why just buying shorts won’t protect you. Let’s say you buy some general market index fund. You’re great as long as the market goes up, but you lose if it goes down. So, you want to protect yourself in that case. If you try to hedge against that by buying a short general market index, all you’ve done is make it so your net gain is pretty much always 0. The two funds will work in opposition. Of course, your net isn’t really 0, it’s slightly negative, as you had to pay some fees/spread/etc. to buy the investments in the first place.
For a better example, let’s say you buy stock in fund XYZ, and you predict that it will do very well, unless there’s some kind of total market crash. So, to hedge your investment, you buy some way out-of-the-money short options. Market goes totally into the toilet, you get rich. Market (and XYZ) go up, you get rich, it’s all great. But you’re still not risk free. If the market goes up, but XYZ doesn’t, then you lose. Your options cost you money but aren’t worth anything, and you haven’t gained anything on XYZ. You’ve protected against the particular failure that you forecast, but you can’t protect against every eventuality.